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Don’t Turn America Into Europe

January 29, 2015

Why are we talking about austerity now when it’s worked so badly across the pond?

The Europeans—some of them, anyway—are finally beginning to concede that austerity has gone awry. There’s less growth, more structural unemployment, little bank lending and economic contraction. And now, of course, we have a political backlash in the person of Alexis Tsipras, the leader of Greece’s Syriza party, who upon winning the prime ministership last Sunday declared grandly (and probably over-optimistically) that Greece will now “leave behind the austerity that ruined it.”

So with all the evidence in, why in the world is the United States poised to embrace its own economics of austerity?

After a somewhat hawkish monthly Fed report described economic growth as “solid” (December’s term was “moderate”), the buzz is about when the Federal Reserve will begin to increase short-term interest rates, which have remained at zero since the onset of the financial crisis more than six years ago. Before that the Fed wound down its quantitative easing program of monthly bond buying. As overall U.S. economic data have improved and the labor market has stabilized, the Fed decided late last year that aggressive and unprecedented monetary measures were no longer required.

The rationale for the Fed to raise rates is that economic growth is humming along at about 3 percent while the official unemployment rate is well below 6 percent. The hawks at the Fed—those who believe that rates should be raised now rather than later on the assumption that where there is growth and a statistically tighter labor market there will soon be inflation—think that it is best to act before inflation starts rather than after.

Yet this “getting ahead of the curve” approach assumes that there is a curve to get ahead of. There is one glaring problem with this logic: There is absolutely no discernible wage growth or inflation, and with oil and energy prices plummeting, even the conspiracy theorists who believe that inflation is hidden or underreported will have a hard time finding it.

Again, the lesson of Europe is instructive.

Greece’s Syriza Party struck a deeply resonant chord throughout parts of Europe that have seen years of economic contraction and stagnation and blame austerity politics. The recent massive move by the European Central Bank steered by Mario Draghi to undertake its own version of quantitative easing was further proof that austerity policies are giving way to spending and stimulus.

Even some European economic officials realize that, judging from the experience of southern Europe, austerity has succeeded not in restoring fiscal sanity but in crippling economic activity. Spain, Italy, Greece, as well as some of the countries of central and eastern Europe took the direction of Germany and the northern powers and slashed spending and focused on reducing debt. The result was less of just about everything—except unemployment. There was a lot more of that.

It could be argued that austerity did yield some results in the United Kingdom and the Baltic States, but the former was never in the doldrums in anyway comparable to the southern states, and the Baltics were willing to pay a high economic price in return for the buffer provided by the European Union against an ever-threatening Russia.

Austerity is first and foremost an economic philosophy. And economic theories of how the world should work can be remarkably resistant in the face of real-world evidence to the contrary. The dangerous power of immutable theory has underpinned the entire theory of austerity in Europe, with ambiguous results at best.

The theory behind austerity is fairly simple: The economic problems of the Eurozone and the United States stem from an excess of debt invested unproductively in assets. Too much government spending directly or indirectly made its way into unproductive assets such as real estate or consumer spending or over-generous safety nets. That was bad enough, but for advocates of austerity, too much debt is the main enemy and reducing debt is the main goal. Debt is seen as the Damoclean sword hanging over an economy, constraining options, limiting growth, and sucking vital capital out of the system to service that debt. And then, if and when governments try to devalue their currency to pay off the debt, creditors pay the price.

Austerity then demanded that countries bring their debt down to an acceptable level relative to GDP. That was and is the theory, that too high a debt-to-GDP ratio imposes a burden on growth and imperils economic health. And that theory had no greater proponents than the Germans, who demanded that debt-laden countries such as Greece, Spain and Portugal drastically curtail public spending, generate more tax revenue, and pay down their debt.

That is precisely what happened. Dictated largely by Germany, but supported by the conservative government in Great Britain and other countries such as the Netherlands, austerity saw deep cuts to government spending in heavily indebted countries of southern Europe. No one had any illusions about how painful such policies would be, with unemployment in Greece and Spain well exceeding 25 percent officially, and economic contraction causing further pain.

In 2011, as these policies were in full bloom, German Chancellor Angela Merkel remarked that the European debt crisis would “last a decade.” That view has proven prescient, but primarily because austerity politics ensured that it would be true. It’s a bit like refusing to drive more than 20 miles per hour and then lamenting fatalistically that it will take five hours to go 100 miles. In any event, asking millions to suffer for a decade is a bit much, and after four years of unmitigated economic gloom, the Greek electorate has finally said “enough!” In its own way, so has the European Central Bank. Enough with austerity without relief. Enough with slashing spending. Enough pain.

The German approach was right in one respect: Without structural reform to labor markets and long-term pensions, without more effective collection of taxes and more dynamic economic systems, neither austerity nor spending would work. But absent structural reforms, said the German consensus, only austerity had a chance of preventing a full-fledged slide into crisis and collapse.

The fact is, no populace muddles through a decade of economic contraction, no jobs and no hope. For Germany and other northern European countries to expect that was foolish. Now, not just Greece but left-leaning parties in Spain and the government coalition of Italy are either rejecting austerity or demanding that stimulus and spending be part of any future mix.

Having not suffered from the depredations of austerity policies (yet), the U.S. government is now flirting with them. Think of the contrasting approaches between the Eurozone and the United States over the past six years. Unlike the countries of the Eurozone, the U.S. passed a massive stimulus plan (c. $800 billion) in 2009 and also moved more quickly to recapitalized and restore the banking system. That was the opposite of austerity. Then the Eurozone followed suit, too late perhaps, as both Britain and the Eurozone undertook stimulus spending in 2010, to the tune of more than $1 trillion. That money, however, was aimed at the economies of the north not suffering from crippling austerity policies. The southern countries that needed such stimulus the most were the ones that received the least of it. Meanwhile, the U.S. labor market and GDP growth started to tick up, and just as they did, the American austerity caucus (championed by the Tea Party) gathered steam n 2011 with the debt showdown.

Unlike in Europe, however, where the ECB was largely sidelined, in the United States, the Fed remained adamantly stimulative. Now, the Fed is moving towards tighter monetary policy just as the federal and state governments continue to cut spending and raise taxes. It may not be Greek-level austerity, but it is on the same spectrum.

It may be that, because the U.S. economic system suffers fewer structural obstacles in the labor market, enjoys a somewhat more liquid banking systems and has fewer barriers to business creation, less federal spending and tighter monetary policy will not much dampen the decent growth the country has been experiencing.

We can only hope. With zero discernible inflation and no wage growth, along with falling annual government deficits (though with increasing overall debt), the reasons for austerity other than economic dogma are questionable.

It would behoove all of us to accept that much of today’s economy is terra incognita. Quantitative easing, a Eurozone linked by a common currency with common sovereignty, globalized finance, the deflationary effects of a global labor force combined with technology—there is no clear antecedent for any of these. But if so much is new, then why follow a 20th century economic script that sees debt as the greatest evil and tight monetary and fiscal policy as the greatest good?

The bloviating certainty of too many that there is one true way forward represents the greatest danger. The harsh German official line—which has psychological roots in the post-World War I hyperinflation that led to the rise of Hitler— sees economic policy as simple and binary. If only that were so. And while the Germans might just be right theoretically, we don’t live in a world where millions of Greeks or hundreds of millions Americans can be the sacrificial lambs to test whether or not the theory works after a decade.

Thankfully, many at the Fed seem aware that decisions such as raising interest rates should be based on a wide array of data and not a simple mathematical formula based on past precedent. Several members of the Fed board including the president of the San Francisco Fed John Williams have strongly advocated not just a gradual change in policy but one that adjusts and adapts to the ever-fluid matrix of new information.

That nimble approach is the opposite of dogma and doctrinaire theory. Let us hope that such attitudes prevail not just at the Fed but in Congress as well. The alternative is a new dogma of austerity that has proven a failure in practice in Europe. Imports of fine French wines, good German cars, and assorted Eurozone luxury goods, that we can justify; imports of rigid and failed economic policies, that makes no sense.

Author’s disclaimer: The opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities, or investment advice or a recommended course of action in any given situation. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. Information obtained from third party resources are believed to be reliable but not guaranteed. This paper may contain ‘forward-looking’ information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this paper is at the sole discretion of the reader.